Friday, July 15, 2011

To All Keynesians: Is There Such a Thing as Too Much Debt?

Keynesians advocate for deficit spending by a government during a recession to make up for declining private sector demand. This boost from public funds is seen to be a temporary catalyst to re-energize the virtuous circle of private spending drives private industry which drives private job growth which drives private spending and round and round we go. What I have yet to hear from the Keynesian argument is the qualifier "Because our public debt has yet to reach X, the government should continue to borrow and spend to support the economy..." So to all Keynesians out there: "Does there exist an upper limit on government debt that is independent of other economic conditions, such as GDP growth?" Or in other words, can a nation reach a debt saturation point where regardless of any other metric, such as negative GDP growth, it becomes more harmful for the government to continue deficit spending? And if the answer to that question is yes, the obvious follow-up would be, how is that limit calculated?

Keynes alluded to the possibility of unlimited government borrowing in a low/zero interest rate environment in "The General Theory of Employment, Interest and Money." I pulled the following quote from a critique of Keynes' "General Theory" by Brett DiDonato (I highly recommend reading it):
There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.
I think every economist would have to agree that in the real world, there is no such animal as "unlimited borrowing." Eventually interest rates would rise to the point that additional borrowing becomes unfeasible. For Greece it was a debt to gdp ratio over 140% and for Ireland it was over 90%. Japan, on the other hand is over 200% and is still deficit-spending with abandon (I'm using the data from EU's Eurostat and CIA Factbook as listed on Wikipedia) So perhaps this a case of, "Yes of course there is a limit to the amount of debt the US, or any country for that fact, can take on, but like a detailed audit of the Federal Reserve, this information is too dangerous for the public arena."

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